Stock Buybacks: An Investor’s Friend or Foe?

'Putting cash to use' sounds nice, but proof's in the pudding

I’m betting you’ve reined in your spending during the recent economic recession and continuing uncertainty plaguing global economies. Our household certainly has! But even with the reduction in consumer spending in the past few years, it’s a sad fact that most households have seen their net worth fall. According to the Federal Reserve, during the third quarter of this year, Americans saw their net worth decline about $2.4 trillion — primarily due to dropping values in our homes as well as in our investments.

But on the corporate front, things are much brighter …

As you’ve undoubtedly heard and read about, corporations have come out of the recession a lot better than households. They were smarter this time around — cutting costs very early, which has served them well. Corporate profits have been heading up for the past year and, according to Thomson Reuters, rose 17.9% in the third quarter.

And instead of rushing out to spend that extra money, America’s businesses have been hoarding their cash. Still rising — some 28% of assets now — corporate cash and equivalents stand at about $2.12 trillion, according to the Federal Reserve.

Traditionally, companies use their cash in five ways:

Cash reserves

Product/business expansion

Mergers and acquisitions

Dividends

Buybacks

While they are keeping their cash reserves high, companies have been very timid at business expansion in the past couple of years. We are beginning to see more money flowing into R&D, and M&A is picking up. There’s been about $2.22 trillion in transactions so far this year — roughly the same as 2010, according to Bloomberg, but we have yet to see a barn-burning run to build business.

Instead, companies in the S&P 500 Index have been putting their cash to use primarily in two ways:

By increasing their dividends

By rushing to buy back shares

So far this year, companies in the index have increased their dividends by about 10%, which has been a nice bit of extra change to many investors. But the buyback trend is much more pervasive.

In the second quarter of 2011, S&P 500 companies spent $109.2 billion buying back their shares — a rise of 21.6%, and the eighth consecutive quarterly increase in stock buybacks. Year-to-date, more than $454 billion in stock buybacks has been authorized — the most since the 2007 peak of repurchases, at $914 billion, according to Birinyi Associates. Companies buying back their shares this year include IBM (NYSE:IBM), Pfizer (NYSE:PFE), Dell (NASDAQ:DELL), Disney (NYSE:DIS), Lowe’s (NYSE:LOW), Coca-Cola (NYSE:KO), Goldman Sachs (NYSE:GS), DuPont (NYSE:DD), Navistar (NYSE:NAV), Intel (NASDAQ:INTC) and Amgen (NASDAQ:AMGN). Even Warren Buffett’s Berkshire Hathaway (NYSE:BRK.B, BRK.A) has jumped on the bandwagon.

Sounds good, doesn’t it? After all, by reducing the number of shares outstanding, the earnings of a company are distributed among fewer shares, so earnings per share effectively rise. And investors love it when earnings increase — no matter the cause — and often reward a company by sending its shares higher.

But astute investors need to look behind the scenes to determine if share buybacks are good for investors in the long run.

Here’s why management likes buybacks:

Most C-suite managers (CEOs, CFOs, COOs, etc.) are awarded bonuses based on increased earnings per share.

Since these same managers often receive part of their compensation in stock options that are dependent upon their company’s share price, they are thrilled when anything makes the share price rise because it gives them an opportunity to cash out their options at higher prices.

When managers exercise their options, the company is issuing or adding shares to their outstanding stock to meet that obligation, possibly causing dilution of earnings per share. Buying back shares prevents that dilution from stock options being exercised. Consequently, it’s possible that the buyback and option share issuance could just be a wash — one reducing outstanding shares and the other increasing them.

As for investors? Companies tell shareholders that buybacks are better for them than receiving dividends, as they won’t be taxed on the buybacks (unless they sell their shares). And, of course, there’s the possible increase in your share price.

Let’s look at the history of buybacks to determine if your share price will really benefit from the buyback. You might be surprised at the answer!

In many cases, stock buybacks do portend a run-up in price, at least temporarily. Looking at the longer term, however, the statistics drastically change. In a study that spanned the past 10 years, Fortuna Advisors found that companies with the highest dollar outlays on stock repurchases actually returned just 37% to their shareholders, compared to the 127% return from companies that used their cash on other pursuits.

Wow! That’s a big difference, isn’t it?

But it makes sense. The business of business is business. That means a company should be reinvesting its dollars in making its business grow — hiring more employees, expanding its R&D and developing new products. New business generally means more revenues, and more earnings. And more earnings tend to impress investors, generating share price increases.

But that kind of growth is not yet happening. According to Thomson Reuters, companies in the S&P 500 Index are on schedule to spend just about $546 billion on capital expenditures this year — less than the $560 billion they spent in 2008!

Nevertheless, analysts are predicting that fourth-quarter earnings for the S&P 500 companies will grow about 10% — a healthy rate, but considerably less than in the third quarter. And the profits still are due primarily to extensive cost cutting, not to business expansion.

My point is this: Companies are not parlaying their cash to create major new business, which is absolutely necessary to speed up the economic recovery. Instead, they are delving into their bags of tricks — one being stock buybacks — that will temporarily boost their earnings per share. And the result most likely will be a positive pop for the S&P 500 earnings numbers.

But don’t be fooled into thinking that this earnings “gotcha” is thanks to solid growth. Look behind the numbers, account for any share buybacks, and only then will you be able to tell if your stocks are truly growing or just fiddling with the numbers.

And above all, don’t invest in a company just because it is buying back shares. That’s just not a good fundamental indicator of a company with great return potential, in my book.